Tuesday, May 22, 2012

Gulfport Energy and Wexford Capital: Part 3

Gulfport Energy - as I have shown in Part 1 and Part 2 - is intertwined with Connecticut based hedge fund group Wexford Capital. All their substantial assets are either jointly owned or operated or both by Wexford entities. The Chairman of the board of Gulfport is - at least in part - a Wexford man.

However Wexford have over the past few years dramatically reduced their holding in Gulfport. In the 30 April 2009 proxy Charles E Davidson (the principal of Wexford) spoke for 15,235,786 shares or just over 35 percent of the company.

After years of sustained selling by Wexford and sustained issuance by Gulfport, Wexford's ownership position is about two thirds lower.

Despite Wexford's reduced holding Gulfport remains tied to Wexford.

Wexford and Gulfport are still doing related party transactions. On 7 May (ie this month) they announced a transaction whereby they are selling their Permian assets in exchange for a stake in a soon-to-be-listed entity called Diamond Back.

There was no specific press release for this transaction - but it was announced via a long 8K. On May 8 they announced their quarterly results which briefly described this transaction. To quote the earnings release:

As previously announced, on May 7, 2012, Gulfport entered into a contribution agreement with Diamondback Energy, Inc. ("Diamondback Energy"), in which Gulfport agreed to contribute, prior to the closing of Diamondback Energy's initial public offering, all of Gulfport's oil and natural gas interests in the Permian Basin in exchange for (i) common stock representing 35% of Diamondback Energy's outstanding common stock immediately prior to the closing of its initial public offering and (ii) approximately $63.6 million to be paid to Gulfport upon closing of such offering, subject to adjustment. Gulfport's obligation to complete the proposed contribution is subject to various closing conditions, including Gulfport's satisfaction with the terms of the Diamondback offering.

The earnings release however does not include the observation that this is a related party transaction. You had to go to the 8K for that. Here is what the 8K says:

On May 7, 2012, Gulfport Energy Corporation (“Gulfport”) entered into a Contribution Agreement (the “Contribution Agreement”) with Diamondback Energy, Inc. (“Diamondback”). Diamondback was incorporated on December 30, 2011 for purposes of undertaking an initial public offering (“Diamondback IPO”) of its common stock, par value $0.01 per share (the “Common Stock”), pursuant to a Registration Statement on Form S-1 (Registration No. 333-179502) initially filed with the Securities and Exchange Commission on February 13, 2012. Diamondback has not conducted and will not conduct any material operations prior to the transactions described below. Prior to the completion of the Diamondback IPO, Diamondback will acquire all the outstanding equity interests in Windsor Permian LLC (“Windsor Permian”), which as of March 31, 2012, owned and operated approximately 30,025 net acres of oil and gas interests in the Permian Basin in West Texas.

Under the terms of the Contribution Agreement, Gulfport agreed to contribute to Diamondback, prior to the closing of the Diamondback IPO, all of its oil and gas interests in the Permian Basin in exchange for (i) shares of Common Stock representing 35% of Diamondback’s outstanding Common Stock immediately prior to the closing of the Diamondback IPO and (ii) $63,590,050.00 in the form of a non-interest bearing promissory note, which will be repaid in full upon the closing of the Diamondback IPO with a portion of the net proceeds from that offering. The aggregate consideration payable to Gulfport is subject to a post-closing cash adjustment based on changes in Windsor Permian’s working capital, long-term debt and other items referred to in the Contribution Agreement as of the date of the contribution. Windsor Permian is the operator of the acreage to be contributed by Gulfport. Gulfport’s obligation to make this contribution is contingent upon, among other things, the contribution to Diamondback of all the outstanding equity interests in Windsor Permian by DB Energy Holdings LLC (“DB Holdings”), Gulfport’s satisfaction with the terms of the Diamondback IPO and customary closing conditions. Under the contribution agreement, Gulfport is generally responsible for all liabilities and obligations with respect to the contributed properties arising prior to the contribution and Diamondback is responsible for such liabilities and obligations arising after the contribution.

In connection with the contribution, Gulfport and Diamondback will enter into an Investor Rights Agreement in which Gulfport will have the right, for so long as Gulfport beneficially owns more than 10% of Diamondback’s outstanding Common Stock, to designate one individual as a nominee to serve on Diamondback’s board of directors. Such nominee, if elected to Diamondback’s board, will also serve on each committee of the board so long as he or she satisfies the independence and other requirements for service on the applicable committee of the board. So long as Gulfport has the right to designate a nominee to Diamondback’s board and there is no Gulfport nominee actually serving as a Diamondback director, Gulfport shall have the right to appoint one individual as an advisor to the board who shall be entitled to attend board and committee meetings. Gulfport will also be entitled to certain information rights and Diamondback will grant Gulfport certain demand and “piggyback” registration rights obligating Diamondback to register with the SEC any shares of Common Stock owned by Gulfport.

The preceding descriptions of the Contribution Agreement and the Investor Rights Agreement are qualified in their entirety by reference to the full text of such agreements, copies of which are attached as Exhibits 10.1 and 10.2, respectively, to this Current Report on Form 8-K and are incorporated herein by reference.

Diamondback, Windsor Permian and DB Holdings are entities controlled by Wexford Capital LP (“Wexford”). Charles E. Davidson, the Chairman and Chief Investment Officer of Wexford, beneficially owned approximately 9.5% of Gulfport’s outstanding common stock as of March 13, 2012. Mike Liddell, Gulfport’s Chairman of the Board and a director of Gulfport, currently serves as the operating member and chairman of Windsor Permian and has an interest in DB Holdings. A special committee of the Board of Directors consisting solely of independent directors negotiated and approved this transaction on behalf of Gulfport.

The related party nature of this transaction requires (and is being granted) a committee of the independent directors.

How important are the Permian assets?

The last annual report (10K) contained a table with Gulfport's proved reserves by field:

Proved Reserves

Field

NRI/WI (1)

ProductiveWells (2)

Non-ProductiveWells

DevelopedAcreage (3)

Gas

Oil

Total

Percentages

Gross

Net

Gross

Net

Gross

Net

MBOE

MBOE

MBOE

West Cote Blanche Bay Field (4)

80.108/100

95

95

189

189

5,668

5,668

352

3,617

3,969

E. Hackberry Field (5)

79.424/100

30

30

93

93

3,291

3,291

226

1,606

1,832

W. Hackberry Field

87.5/100

2

2

23

23

592

592

—

76

76

Permian Basin

35.4/46.87

121

57

—

—

8,880

4,119

2,008

10,877

12,885

Niobrara Formation

39.7/47.9

6

3

2

1

3,954

1,977

26

500

526

Williston Basin (6)

2.8/3.3

6

.2

—

—

1,708

132

7

67

74

Overrides/Royalty Non-operated

Various

133

.2

—

—

—

—

3

2

5

Total

393

187.4

307

306

24,093

15,779

2,622

16,745

19,367

12.9 million of the 19.4 million barrels of oil equivalent in the proved reserves is in the Permian Basin. On this table Gulfport has sold the bulk of its proved reserves to a related party.

In their defence - after the transaction they own 35 percent of the related party which is lower but not massively lower than their prior ownership of the field. All that has happened is that they have lost control of the assets which they directly owned and are now owned by a Wexford entity. In this I presume the Wexford interests in those assets were also contributed and on similar terms. [I do not know - I am just giving Wexford the benefit of my doubt...]

Whatever: losing control means that they also lose control of the cash flows from these assets. Moreover as they own less than 80 percent of the assets if they get these cash flows out there will be a tax event. The 8K quoted above envisages a sell-down of the assets. This transaction does not make sense from a tax perspective unless that sell-down happens. So I presume a sell-down is expected.

As a shareholder it seems you are swapping productive assets you know for some cash which will (presumably) be used to develop other assets. Some of that cash only arrives when the IPO of Diamondback happens. There is nothing obviously wrong with that - but the related-party nature of the transaction does raise governance risks which make shareholders dependent on the non-executive directors to guard their interests.

4 comments:

Anonymous
said...

PART 4

Insider selling, ownership and incentives alignmentNow If we think from Wexford’s perspective, about its 50% investment in Utica, 75% in Grizzly, to an extent Niobrara and elsewhere (which I am discussing not in great detail as it could be thought of as option value). Wexford would want Utica and Grizzly to be homeruns for its LP’s. Does this make a bad scenario of GPOR? No, in fact it is a case where GPOR should continue to benefit with Wexford’s capital, probably its greater financial oversight (owing to PE operators, etc.). One should think of that how and when would Wexford monetize these. The answer that one can think of is that it should not be soon as these properties are in the very initial stages of development. So not before the next 4 years or so at least! And both parties would want their interests to be much higher in these investments by then. Also, it is important to understand GPOR’s history. It was formed in 1997. Initial assets were of bankrupt WRT Energy and WCBB contributed by DLB Oil. Now, Charles Davidson had been selling his private share in GPOR in the $30’s and it was down to 9.5% as of March 13 2012. One would think that he would want to still have majority ownership in GPOR’s shares so that there could be some influence from being the biggest shareholder (given GPOR has a very good opportunity in Utica in the immediate future). The next biggest shareholder being 5-6% or so, one could “guess” him not reducing his stake much below that and not at this stock price. The 3% or so would amount to around 1.5MM shares or so. At 10% of the 800k volume, it would amount to 20 days if someone is trying to sell in open market without affecting price. So this should have already passed till now or he could wait for sometime in future when the price is above $30. So in any case, it makes little sense of diluting ownership stake completely given Wexford has collaborated with Gulfport in Utica again. To think from Wexford’s perspective, given that it is a hedge fund, given it wants to generate outsized returns relative to market and risk for its LP’s, one way to think is that it thinks GPOR to be good operator given its continued association.

Shales and GPOR’s Utica exposure:Just a quick note about shales. I think most people could be unaware of a couple of points.1) Traditionally oil and gas business is considered riskier due to the inherent risk of reaching a dry hole when drilling. In shales, this risk is extremely minimized because we are digging into the source rock where oil and gas is itself formed under high pressure and not where oil and gas goes and stores like in traditional drilling.2) Shales were discovered many years ago but it was extremely difficult to drill into the source rock some 7-10k feet underneath and drill for oil and gas that was “commercial”. Commercial is the key word here. The reason was of extremely low permeability and porosity in these rocks. However, with fracking and new technology and higher prices of the underlying commodity, this risk has been much minimized. Hence we are able to define massive areas with shales. The consideration here remains of pressure and other infrastructure to support production.Hence, it is very important first for a company to acquire land in resource plays (resource plays are defined as large expansive areas where there is accumulation of HC’s) and that too in the heart of resource plays. Second, there needs to be sufficient sand/proppants, gathering/processing/takeout capacity for the production to not be bottlenecked or not go at a big discount to market (as in the case with Bakken right now). If you look at these couple of points, GPOR has done a phenomenal job till date with area in the heart of the play (at below $5k per acre), setting up of the sand facility, relationship with Markwest, etc.

For all those people who are concerned about the shutting down of wells in Utica before producing, this was discussed by the company in an industry presentation last month. Also, a few other operators/companies mentioned about this phenomenon. So, production delays due to this should not be of big concern to long term holders. Yes, corporate governance, management, hard asset value, etc. are which we are discussing here.

GPOR vs. other stock opinions and shorts:I highly appreciate the value of different opinions as it forces one to dig deeper. Coming to the track record of people shorting China ADR’s, it is a known fact that ”till now” majority has made a lot of money on this trade (CAST in recent past has really hit the space again and the stories keep on continuing). It can also be thought of overweighting (from the short side) an asset class. Not a classic short pick story. NOG on the other hand is a story that can be highly susceptible to shorts given its handful of employees, non-operating assets, other blemishes during the ride from being penny stock, etc. While NOG has not been proven right till now, many China ADR’s in many cases were classic cases of irregularities in accounting, missing assets, dishonest managements, statement manipulations, executives moving company money into personal accounts, irresponsive to investors, false cash, etc. None of this is the case for GPOR. All the related party transactions are disclosed as required by law in the SEC filings. The fact that there exists related party transactions disclosure and companies disclose them in their SEC filings does not make those businesses inexistent. It probably encourages more skeptical minds.

Permian deal, operations and reserve growth: Anyways, with respect to GPOR, while it might be hard to appreciate the Permian deal at first, understanding the history, backdrop of various events, etc. has really helped. The Permian deal if goes ahead, management has reiterated would be accretive to shareholders. Back of the envelope valuation could around $200M. So give a discount 20-25%, it should be at least $150M ($10k-$12k per acre). Also, a fact to be noted is that the 35% ownership in stock of Diamondback and $64M cash is derived from the fact of Permian acreage. There are many locations where GPOR and Windsor have 50-50% JV’s and many locations where Windsor is the sole owner. So the 35% for people who might be thinking curiously about this. Of the PDP GPOR currently has, more than 80% come from Louisiana. So there is not a much of a hit to the PDP as there is to proved. Now think about Utica. If GPOR drills 20 gross wells this year, 10 gross wells start producing (5 net wells), approximate EUR each is 500MBOE, plus you can take one offset as PUD. So there will be in essence with 5 net producing wells, 1 offset PUD location and 500Mboe EUR of each, 5*2*500MBoe=5MMBoe addition to proved reserves this year. With 50, 50 and 70 wells expected to be drilled in 13, 14 and 15, most part of leases should be held by production. 200 wells are required to be drilled for lease to be held by production. Agreed, every well in the lease won’t be a blockbuster and western oily parts with less pressure and east parts with dry gas, we can take EUR to be 450Mboe or very conservative 400MBoe (this should be at real low ends for Eagleford too). So there should be reserve additions of 20MMboe, 28MMBoe and 28MMboe each of these years (not taking the production lag effect into account for simplicity). So there should be significant ramp in production. This is at 640 acre spacing; so there is significant infilling inventory for future as well. As GPOR builds this, it should be able to access debt via bank as wells start producing and for the last leg might issue equity if the stock price appreciates enough. Plus everyone knows the attractiveness location where GPOR is starting to drill is between CHK’s and APC’s. Also, CHK’s record production Beull well was close and north of GPOR’s acreage.

Assets and Valuation: In US, oil and gas is a highly regulated industry unlike elsewhere in the world. Production data on each well, well location, etc. is available easily. So comparison of cases with some of the China ADRs where the revenues itself were not present, etc. is different. So assuming that GPOR has all the leases, rights to production, etc. we can do a very basic back of the envelope hard asset valuation. There can be multiple ways to do it on proved reserves basis, assigning weights to unproved or probable reserves and then the resource potential value. I am not going into the basics of each of the area as we can find it elsewhere in most research notes.

A crude way with very conservative estimates (worst case valuation): Permian for $150M as above indicated ($10k/acre or $15/proved MMBoe), Utica $300M which should accelerate much more in the future (62.5k acres and $5k per acre), Niobrara at $50M (15,300 acres and $3k per acre), production cash flow from Louisiana at 5 times at $500, and Grizzly with 200k net acres at $200M to $1B (whatever way we want to value with $5k per acre in some deals at $2B or conservatively $10 per MMBoe times 16.75 + 11.75*.5 = $200MMboe). Then Thailand is more of an option value and good points to the management for diverting away this year’s capex from Thailand development, which not many people noticed.

Note that in the above case, I have tried being extremely conservative by:- Valuing Permian on proved reserves and what they are expected to get by IPO and using a 20-25% discount to that.- Utica valued at $5k per acre. When many operators tell it is difficult to get at these prices. Plus the fact the value of a sizable position increases much more for a bigger conglomerate than a one unit position.- Niobrara at $3k per acre (lower end of estimates)- Since Louisiana is the only place where they have current existing production, it makes much more sense to value on production as done for royalties than on reserve basis. Because the production number incorporates the original borne development costs. Royalty multiples on revenues generally range between 7 to 12 times cash flow. Be it however you take it, if one assumes they did 2MM boe from Louisiana even at $50 per barrel margin (which is lower than they make), that will take you to $100M and put a very low 5 multiple on that. Or one could simply put a multiple on their 2011 CF. Anyways, just the royalty multiples that are off the top line go on an average at 8-9 times. So if you put a multiple of 5 that too on below the expense line, I think it is conservative.- Grizzly can be taken as $1B (200k acres at $5k per acre) or lets say since all acreage is not same at $3k per acre to be around $200MM. However, being more conservative I have just taken on their proved reserves and one third of probable reserve valuation. Plus the range of MMBoe of proved reserves valuation is $13-$17. Yet, I have taken it as $10 attributing to the fact that it is in the sands where margins are a bit lower due to thick/tar nature of oil. I am not taking any value of the production numbers that management is reiterating.- Have given no value to Thailand.

So in a liquidation value scenario, with what I believe are quite conservative numbers, we can come up with minimum of $1.2B of value. Using midway bw. worst case and base case assumptions, one can easily think of a $1.5B valuation. The base case value should be around $1.8B-$1.9B (Niobrara - $75, Utica - $400, Permian - $175, Louisiana - $700 and Grizzly - $500M). The bear scenario hard asset value is where all these assets are with a person who does not know how to operate it. But that is basic difference between owning an asset or building a business by owning and operating assets efficiently and that is why one pays for it. So we can ourselves think about the share value but the beauty of stocks is that they mostly always shoot up and shoot down much more than the fair value.

GPOR perspective:The positives that differentiate GPOR from its peers are1) Diversified assets (apart from Louisiana, Utica, Permian it also has significant assets in Canadian sands and some in Niobrara).2) Existing production out of legacy Southern Louisiana assets that could fund growth of Utica assets. One of the few companies with exposure to Utica and one of the few with existing cash flow funding for capex.3) CEO is trustworthy and very technically oriented (good operator).4) Has no debt. Very few companies in small E&P have no debt. Provides downside support in bad scenarios. One should think that this is unique in the sense that management could have issued a lot of debt (eg. GMXR), but management has operated it conservatively for which appreciation should be given. Optimal cap. structure can be arrived at some time later. So, having no debt is a huge benefit in case every bet turns against you giving you a floor based on just hard asset valuation.5) Has over 95% oil weighted production. Provides downside floor in distressed NG pricing scenario.6) Over 85% of the production is priced as Louisiana sweet that is generally at a $15-$20 premium to WTI. It was volatile this quarter and was around $%-$10 premium (also resulting in some earnings miss).7) Lower tax rate due to NOL's that would last a minimum of 3-4 years more.While some of these points can be spun to thought from a speculative negative side as well, there should be very few companies with all these attributes together.

Bottomline, while all the above information does not 100% rule out any possibility, it makes us think more deeper about how a business is actually conducted, about hard asset value, future growth, and while PE association is not highly desirable (as all of us in the stock market want certainty and simple structures) it does not erode the value of the assets (though one can argue, it might put a lower multiple on earnings or in this case Net Asset Value discount). The first Utica well is expected to start producing in August. If the Q2 call is a week or two into August, we should be able to hear IP rates from the same.

While I have a long position in the stock for disclosure, I have been doing this research from the time of the earnings release on May 8. Just happen to post what I learned here. These are my opinions. Please consider this as no endorsement or recommendation of any side of position in the stock. And this should not be considered in making any investment decisions.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.